January 29, 2010

Clarifications on previous post

The special situation discussed in the previous post was a delisting announcement by Elantas beck. The plan was to benefit from the price appreciation between the deal announcement and the actual delisting.

A few Comments and some emails on the previous post made me realize that understanding delisting norms is really not everyone’s idea of fun. So let me try to explain it in brief (while omitting some details)

If you hear a thud sound while reading this post, it is likely you have fallen asleep and hit your keyboard while reading this post :)

Delisting process
You can find the delisting norms
here. In brief, the rules for delisting apply when a company wants to delist all its shares from the exchanges (i.e go private with no public shareholding). It needs to go through a prescribed process which can be described in short as follows

1. Board approves delisting

2. Company seeks shareholder approval for delisting the shares. For the delisting to be successful, the company has to buyback atleast 50% of the publicly held shares. So if the public holding is 11.5 % (as in case of elantas), then the minimum buyback has to be 5.75% of the total shares for the company to delist from the exchange.
3. Shareholders approve the buyback.
4. The company launches reverse book building to discover the price at which it can buy 50% of the outstanding shares. The shareholders tender their shares to the company at their desired price. If the company finds that more than the outstanding number of shares have been tendered and the price for the 50% of the shares tendered is within their target price, then they can declare the offer successful. The company is then obliged to buy all the shares that have been tendered at or below the declared price.

Let’s try to understand this with an example. For simplicity, let look at the case of elantas beck.

Elantas announced a delisting and the share price jumped from 250 levels to around 450 levels in response to it. Finally the company announced on 7-dec, that the board has approved a buyback with a floor price of 219 which is the minimum price based on the delisting norms. In addition the board approved a price of 330 as the offer price. This would be the minimum price paid to the shareholders, if the discovered price turns out to be at or lower than 330 during the reverse book building process.

The price was steady around 470-480 levels and as the reverse book building date approached, it crept upto around 500 levels. Finally after the first two days into the book building process, only .5% of the shares had been tendered and the price in the open market was around 525. As the probability of the success of the offer was low, I exited the stock completely booking around 7-8% gain over the deal.

At the end of the tendering period (around 6-7 days), the company received about 25-30% of the outstanding shares and hence irrespective of the price tendered (which ranged from 210-1100), the offer was not successful (as less than 50% of the shares had been tendered).

About the company
It is not crucial to know about the company in detail in an arbitrage or special situation such as delisting. However when analyzing such a deal, it is important to have a look at the fundamentals of the company and evaluate if the company is overvalued by a large margin at the current price.
Elantas beck is into specialty chemicals for insulation and construction industry. It has performed well in the last few years with an ROE in excess of 20%, zero debt and a 10% growth in bottom line. The company has cash equivalents of around 35 crs which is almost 10% of the market cap. At the time of delisting the company was selling at around 16-17 times earnings which is right around fair value of the company.
If the valuation at the time of the announcement is high, the downside risk of the deal is high if it fails.

The calculations
The matrix in the previous post is the expected value analysis. The formulae for expected value is gain*probability of gain+loss*probability of loss.

I estimated that the delisting price would be around 580-600 and hence there was an upside of around 100 Rs. On the downside I expected the price to drop to around 360-370 levels and hence a possible loss of around 110-120 Rs. The probability estimates for each of the events was a subjective number and it depends on one’s experience and guess.

All this work for a measly 7%?
The return was around 7% for 1.5 months, which works out to 56% annualized. My return expectations are 20% per annum from arbitrage over the course of the next few years. There will be some deals which will work out well and some where I will lose money. In aggregate i am targeting 20% or more. I don’t expect too much from myself :)

The advantage of arbitrage is that the returns are not correlated to market returns. If you can evaluate the deals well, the returns are independent of the market. This helps in reducing the volatility of the portfolio and it is always a better to have an additional tool to invest and make decent returns.

16 comments:

Madhav said...

Rohit,

I am new to this sort of thing and so don't understand this well. Just a couple of Q's:

1. If the board is offering to purchase the stocks at Rs.330, why does the price go north of that and even approach 500?

2. How do you sell shares to the company as against to any other buyer, because if I login to my brokerage account and hit 'Sell', I do not know who is at the other end of the deal.

Cheers.

Lucky said...

Hi Rohit,

Nice post. But not enough.

Now that you have started the topic, please educate us more.

And BTW, congratulations on the 56% return :-)

Anonymous said...

Thanks for doing the effort Rohit.

Its very clear now. I am not familiar with the maths for this and was trying to work it out on my own. But now I understand and agree with your calculations.

Thanks,
Anon2

Vic said...

Rohit,

Great to hear that you keep experimenting with these.

I agree with Lucky..u can't get away. You have to educate us more.

Matter of fact, I was quiet awake reading this post..:-)

Thanks,

Vikas

Bala said...

Hi

I am following your blog for some time and thanks a lot for all the insights.

This is a very nicely written article. Apart from delisting, what are the other arbitrage or special situations that we can benefit out of?

Keep the good work going !

Thank you,

Bala

Amit said...

what made you believe that delisting price will be 580?

Rohit Chauhan said...

Hi madhav, amit
to you question - why assume 500 or higher ..typically the management will announce a floor price only. they dont control the price at which majority (>50%) of investors will submit their shares. typically you would assume that the key investors would look at the company and submit at or slightly higher than the fair or intrinsic value of the company. a price lower would mean they are giving back the company for cheap ..at a very high price the management may not accept.

so as an arbitrageur one has to figure out the fair value to estimated the expected returns and hence the above computations

rgds
rohit

Rohit Chauhan said...

Hi vic,lucky
i will keep publishing more ideas as they materialise.

hi bala
there are other arbitrage situations like mergers, splits, bonus issues, warrants, spinoffs where one can make decents returns over time

rgds
rohit

Anonymous said...

Rohit,

You still did not answer the question as to why 480-500???

I along with everybody else would want to know in a field where estimating precise fair value is a tad impossible, how could a Arb estimate it

You are up against fairly decent competition in this field, and it is mainly arbs who keep a tab on things way beyond what you can

I am intrigued to say the least, how is this precision possible or is there a large dose of luck and gamesmanship involved

Anon2

Rohit Chauhan said...

Hi anon2
i think i answered your question - i have calculated the fair value as 600 and used that to calculate the upside. dont know the 480-500 number you are referring to.

yes, estimating exact fair price is diffcult ..some you use an estimate. finally this involves an element of subjectivity like all other investing ..still you can make reasonable assumptions and it works out.

arbitrage like other forms of investing is a mix of art and science ..so there is no precision here ..especially around the probability which is even more subjective. thats where experience comes in and luck definitely helps. but if you work on +ve expected gain cases, overtime luck evens out and you will make money

yes there is competition here ..but then its no different than other part of the market ..again my advantage is that i dont do this for a living , so i bet on cases where i have some understanding and think the risk is low

rgds
rohit

Rathin Shah said...

http://www.lmcm.com/differentiated_thinking/tlf_archive.aspx

This has some good essays by Legg Mason Capital Management's Chief Investment Strategist, Michael Mauboussin.

Hope you enjoy.

Regards
Rathin

Anonymous said...

Hi,

Anon2 again

Leave the probability aside, I want to know about the price specifically

"again my advantage is that i dont do this for a living , so i bet on cases where i have some understanding and think the risk is low" - Nice Answer

But what special talent did you bring to the table as far as this specific deal was concerned, what sort of understanding, which you could not have been able to apply in other delisting deals

"still you can make reasonable assumptions and it works out" - Feels good after it works out for sure :)

Key is over time it works out and you pray that one deal does not scuttle the profit from five others :), it's a minefield I tell you

An iron clad rule of Risk Arb is not to have too many gaping holes in the thesis specifically when the margin of error is so low and the downside in most cases exponentially outweighs the upside

I want to learn from you how you weighed this deal and how you arrived at your calculations

Thanks in Advance

Sachin said...

As currently NTPC FPO is offered for Rs 201 whereas CMP is approx 210. Do you see similar arbitrage here i.e. upside of 5-10% till the allotment.
Though it is FPO thus limiting the number of shares allotted but for small investor like me its will be still good. Thanks Sachin

Rohit Chauhan said...

Hi anon2

you should stop being anonymous ..you are bringing out valid points.

you need to specify what you want to understand about arriving at the price ?

price of delisting : no one knows that in advance ..it depends on what price 50% or more investors submit the shares and if the company accepts it.

one can assume that the market is rational and hence investor will submit at or above fair value. so i did a DCF analysis, analysed the company fundamentals and arrive at the likely fair value of 600. is that the true price ..who knows ? its my guess

the upside price was based on fair value of the stock and downside on the pre-deal price with a small upside as such stock dont return based to pre-deal levels even if they fail.

does that answer your price question ?

typically i analyse the probability of the success based on the amount of public shareholding, instutional holdings, financial position of the promoters, info from company secretary and merchant banker and finally mix all togther and form a subjective opinion.

the probability in hindsight were wrong ..this was pointed out my friends and as a result i changed my approach and got out in the middle of the delisting as it became clear that the delisting was going to fail.

i have had arbitrage and other picks go bad on me ..i would be lying or smoking something if i thought it did not.

yes i could lose money in one deal which i have made in other five ..thats called risk and ignorance ..it can happen to me and my approach to managing the risk is to bet very small sums now.

i have allocated only 2% of my portfolio to arbitrage as i am in a learning phase ..call it tution money..if it works for 2-3 years i will increase the allocation. if i lose money and have egg on my face ..i stop doing arbitrage. part of learning and playing this game.

thats not knew to me though ..thats how i learnt how to invest 10 years ago ..burnt my fingers a couple of time and learned. would be same this time too

Rohit Chauhan said...

Hi anon2
if 525 is the price you are referring to, then the logic was as follows

the price prior to the delisting was around 470. based on experience (which my friends arpit and ninad shared and i have seen the same happen), there is a 10-15% jump in price prior to delisting as investors start buying. if the delisting is successful it would approach the price at which the management agrees to buy or else would drop back to pre-delisting levels.

based on the above logic i decided that a 500-525 range would be a decent price to exit, especially if the delisting is unsuccessful

rgds
rohit

Ninad Kunder said...

Hi Anon2

Let me add to some of the points that Rohit has put thru.

In any arb/ spl sit deal there are 3 risk points associated with it

1) Deal Risk
2) Price Risk
3) Time Risk

Let me address each of this risks with respect to the Elantas opportunity.

1) Time Risk - Time risk was elmininated by constantly monitoring the milestones achieved in the deal. The entry point was timed only post the shareholder approval and once the company had filed with the BSE for the delisitng process.

2) Price Risk - There were 2-3 ways to handle price risk.
a) One as Rohit pointed out was to ascertain the fundamentals and we arrived at a fair value of Rs 600.
b) Inclination of the parent company - Elantas is owned by Altana which is a large chemicals major in Germany. The interesting point is that the largest shareholder of Altana is taking Altana private and Elantas was the only listed subsidiary in the world. market cap of elantas was 360 crores. So the parent would have had to cough up about 40-50 crores to do the delisting. Not a big amount considering their balance sheet to cough up 15-20% more.
c) Expectation of market particpants. When the delisitng was announced ICICI emerging star had about 2,25% stake of the remaining 11% which they exited around the 460-470 mark. So market particpants who bought that 2.25% clearly at that price bought it with a intent to tender it at a higher prices in the delisting process.

Factoring in all the above variables Rs 600 was a reasonable estimate for the delsiting price.

3) Deal Risk - which brings us to the most imp variable in this transaction. We saw a high deal risk bcos of the dispersed nature of shareholding and out of the 8 lac outstanding shares there was 2 lacs in the physical form. Though the current SEBI amendment has allowed physical holders to tender in the delisting process we saw not too many shares getting tendered at that front. Factoring in a high deal risk we defined 2 clear exit points

1) Price point - 520-525 levels
2) Time point - Exit midway thru the bookbuilding process.

The call was clear not to wait till the bookbuilding process closses and take whatever money was available on the table and not live with the deal risk.

I hope this elaborates more on the thought process

Ninad